Pensions & Investments (September 07, 2020) - Before the pandemic, everyone wanted to invest in the largest coastal cities that were thriving, thanks to easy access to work and play — but things have changed.
The open question that managers and investors are having to answer now, without the benefit of transaction data or across-the-board write-downs, is how to position real estate portfolios for the long term.
At the moment, few real estate managers want a high rise in a big coastal city. Some are following millennials to the suburbs from the cities or grabbing smaller buildings, such as garden-style apartments and low-rise office buildings located adjacent to cities. The once-hot cities of San Francisco and New York are being replaced by less expensive cities such as Phoenix, Boston, Denver and Austin, Texas, where people and companies can get more space for their money as telework becomes normalized and social distancing, air filtration and other health requirements are incorporated into office design.
These trends are driving investors to reconsider their core real estate portfolios.
"Core used to be cities, and cities are not going to recover for a long time," said Molly A. Murphy, CIO of the $17.1 billion Orange County Employees Retirement System, Santa Ana, Calif., during its July 29 board meeting.
Core, open-end real estate funds historically leaned toward major coastal city markets, Ms. Murphy said. However, it was those urban centers that came back much quicker in the last financial crisis, she added. During the pandemic, it will take longer for people to feel comfortable using crowded public transportation systems and stepping into an elevator.
What's more, rebalancing real estate portfolios in response to the new normal has become a challenge with longer and longer lines to get money out of open-end funds. Many open‐end fund real estate managers are suspending or limiting redemptions to preserve cash and protect assets of the funds, according to a Townsend Group report to the $7 billion New Mexico State Investment Council, Santa Fe, for its August meeting.Redemption queues have grown to about $19.8 billion as of June 30, substantially higher than $14 billion at the end of the first quarter, the Townsend report said.
Some investors such as OCERS are hedging their bets, looking to make commitments to global real estate funds that can invest in either debt or equity, as well as niche managers experienced in investing in the distressed assets expected to pop up all over the biggest cities.
But the lack of real estate transactions is making it difficult for managers and investors to assess their current portfolios.
"There are not a lot of trades, which is why we're not seeing a lot of write-downs," said Avi Shemesh, Los Angeles-based co-founder and principal of real estate manager CIM Group. Banks are giving borrowers more time to pay their mortgages, he said.
"And this is helping provide an excuse to keep valuations higher than what we think they should be," Mr. Shemesh said. The ODCE index (NCREIF Fund Index-Open End Diversified Core Equity), was down 1.5% during the second quarter, he said.
"If you look at the underlying assets, you see malls. Are you for real with these numbers?"
At the end of the day, real estate will be down generally about 7% to 10% in the coming months, with larger decreases in some sectors such as malls and hospitality, Mr. Shemesh said. Other sectors, such as multifamily, will perform better.
The move out of the largest cities may only be temporary, some industry experts said.
"I think the move to the suburbs story is true but overblown," said Jim Costello, New York-based senior vice president of real estate data company Real Capital Analytics Inc., in an email.
He said investors should underwrite a temporary decline in prices in places such as Manhattan and San Francisco, but not a permanent shift.
"That said, we have not seen much of a move in pricing yet," Mr. Costello said. "The issue is that deal volume is still falling and we are not going to get to a good price discovery phase until a lot of distressed assets hit the market."
The real estate industry is "still in the shock and triage phase where investors are assessing where they are at," Mr. Costello said.
In New York, for instance, there is a disconnect on price between property owners and potential buyers, with potential buyers' price expectations 27% lower than that held by current owners, Mr. Costello noted in a Aug. 27 blog post quoting research by the MIT Center for Real Estate's Price Dynamics Platform.
Even so, in Manhattan prices have barely budged, with the RCA Commercial Property Price indexes down only 2% in June from February.
Jonathan Gray, president and chief operating officer of the Blackstone Group Inc., said he expects that over time people will return to office buildings.
"It's very hard to run businesses remotely," Mr. Gray said during Blackstone's second-quarter earnings call July 23. "We think there will be less density. There's certainly going to be a lot less new construction."
Blackstone executives think the issues involved in the office and hotel sectors are "cyclical in nature" and there should be good investment opportunities. In the office sector, Blackstone is concentrating on properties for life science, technology and media company studios and offices. For example, Blackstone's core-plus open-end real estate fund, Blackstone Property Partners, entered into a $1.7 billion transaction in film studios and offices in Hollywood, anchored by content creators Netflix Inc. and Walt Disney Co.
"In retail and closed malls, where we think the challenge is more secular, then we're going to be more hesitant in putting out capital," Mr. Gray said.
About 13% of Blackstone's assets are in hotels and retail properties, he said.
"We don't have a large number of what we think of as deeply troubled assets," Mr. Gray said on the earnings call.
The COVID-19 crisis and ensuing recession is accelerating a trend that was already underway: the move to the suburbs from the cities, said Benjamin Adams, CEO of Beachwood, Ohio-based real estate manager Ten Capital Management LLC.
"We have long believed in the structural demographic shift to the exurbs and suburbs," Mr. Adams said, citing research by William H. Frey, senior fellow, metropolitan policy program, at the Brookings Institution.
Demographic shifts that had stimulated central business district office demand were already reversing, pushing economic activity to suburban and secondary markets, he said.
For instance, more members of Generation X and millennials are expected to have families and move to the suburbs and secondary markets for a lower cost of living and higher quality of life, Mr. Adams said.
Still, the excitement and convenience of big cities cannot be dismissed, he said.
"Never bet against the big city over the long term," Mr. Adams said.
But in the near term, people and companies have been moving to the suburbs and this trend is accelerating across the country, he added.
For example, properties in the suburbs of Philadelphia such as King of Prussia and Malvern have performed better than the center city of Philadelphia because it is less expensive to own and rent an office in the suburbs, Mr. Adams said.
In July, Ten Capital acquired a Class A office building that was 89.2% leased in the Cypress Creek submarket of Broward County, a suburb of Fort Lauderdale and Boca Raton, Fla. Ten Capital executives found more than the typical competition for the property and competition for these types of properties, particularly in the Southeast, will continue to grow, he said.
Even so, Ten Capital executives are not seeing as many investment opportunities as before the pandemic, Mr. Adams said.
"We are wary of any distress coming off the shoots of COVID-19," he said. "Smart property owners will sell off real estate to protect their gems."
Michael Levy, CEO of real estate manager and developer Crow Holdings, agreed that the trend of people and companies leaving the largest West Coast and Northeast cities for the Southeast and the Southwest is speeding up due to the pandemic and ensuing recession.
As a result, new opportunities in real estate are emerging as industrial space expands to meet the growing e-commerce needs in these markets, Mr. Levy said.
That is not good for megacities over the next few years, he said.
"Even if 5% or 10% of the people leave, it has a very big impact on prices and values," Mr. Levy said. "There will be some distress in megacities like Los Angeles, New York and San Francisco, and opportunities to acquire quality assets at lower prices vis-a-vis the last five years."
Big gateway cities can't be written off though because people still want to engage with one another, he said, echoing the view of Mr. Adams.
"Business is a competitive sport, wins and losses occur at the margin," Mr. Levy said. "Videoconferencing has come of age and Zoom is a great tool, but you can't perpetually run your business on it. You can't."
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